The Three Secrets to Trading Momentum Indicators

164 Pages·2010·14.71 MB·English

by  David Penn

e
A MArketplAce Books trading
guide
THREE SECRETS
The
TRADING
to
MOMENTUM
INDICATORS
David Penn
The
THREE SECRETS
TRADING
to
MOMENTUM
INDICATORS
DAVID PENN
MARKETPLACE BOOKS
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Copyright © 2009 by David Penn
Published by Marketplace Books Inc.
All rights reserved.
Reproduction or translation of any part of this work beyond that permitted by sec-
tion 107 or 108 of the 1976 United States Copyright Act without the permission of
the copyright owner is unlawful. Requests for permission or further information
should be addressed to the Permissions Department at Marketplace Books®.
This publication is designed to provide accurate and authoritative information in
regard to the subject matter covered. It is sold with the understanding that neither the
author nor the publisher is engaged in rendering legal, accounting, or other profes-
sional service. If legal advice or other expert assistance is required, the services of
a competent professional person should be sought.
From a Declaration of Principles jointly adopted by a Committee of the American Bar
Association and a Committee of Publishers.
ISBN: 1-59280-378-4
ISBN 13: 978-1-59280-378-1
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Table of Contents
iv Preface 56 Chapter 5: Price and
Patterns
vi Introduction
The 2B Test
1 Chapter 1: History of
Channel Breakouts
Momentum Indicators
and Breakdowns
What are Technical Indicators Triangles
and Oscillators?
Pennants and Flags
What is the Difference
Between Trend and 76 Chapter 6: Stochastics—
Momentum Indicators? Kings of Momentum
A Brief History of Crossovers
Momentum Indicators
Divergences
11 Chapter 2: Markets and
The Hinge, the Hook
Momentum
BOSO: A Better Way?
Breakout Trading
Swing Trading 94 Chapter 7: RSI—Momen-
tum’s Problem Child
Reversal Trading
Divergences
Using Momentum Indicators
Failure Swings
Momentum, Methods,
and Systems Chande’s Critique and
StochRSI
22 Chapter 3: Introduction
111 Chapter 8: MACDH
to Japanese Candlesticks
How Do Candlesticks Work? 123 Chapter 9: Moving
Average Trios
33 Chapter 4: Japanese
Candlestick Patterns 129 Chapter 10: TRIX
Basic Single Line Hutson’s TRIX
Candlesticks
141 Conclusion
Single Line Patterns
145 Bibliography
Multiple Line Patterns
Trading with Candlesticks
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Preface
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Preface | v
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Introduction
I’ve started writing this book more times than I care to remember. And
that’s probably because it took me awhile to fully realize what it was
I wanted to say about technical analysis in general, and momentum
indicators specifically.
There are three things about technical analysis and momentum indica-
tors that many traders either are not aware of, or continue to ignore.
These three “secrets” of momentum indicators are what this book is
all about. In some ways, these three secrets will support conventional
wisdom about price action, momentum, and technical trading. In other
ways, I think these secrets will come as a surprise to many market tech-
nicians—and will be a worthwhile introduction for newcomers.
In either event, my hope is that by revealing and discussing these se-
crets, the average chartist and trader will be able to make better use
of momentum indicators and become a more confident and profitable
market technician.
Here are the three secrets of momentum indicators:
1. The best indicator of momentum is price action. And the best way
to read price action is by way of Japanese candlestick charting.
2. Some of the most popular momentum indicators—such as the
stochastic oscillator—are far more effective when used differ-
ently from the way most traders use them.
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Introduction | vii
3. “Trend sensitive” indicators such as moving average trios, the
moving average convergence-divergence histogram (MACDH)
indicator, and the triple-smoothed exponential moving average
(TRIX) are among the most valuable tools for the momentum
technician.
These are the three secrets that this book will share. I will also spend
some time talking about the origins of momentum indicators like rate of
change, as well as how some of the standard momentum indicators such
as the Relative Strength Index (RSI) are traditionally used.
Most of the book, however, will be spent on the above three secrets that
can help momentum technicians make the most out of the momentum
trading opportunities that develop every day, every hour, and every
minute in the financial markets—from stocks and bonds to futures and
international currencies.
Traditionally, momentum indicators have been in a tricky position. The
standard criticism of technical indicators is that they lag price action
and thus tend to provide trading signals that are too late. This, for ex-
ample, explains the widespread preference for exponential moving av-
erages, which weigh recent price action more heavily than older price
action, over simple moving averages, which treat all price action equally.
Momentum indicators, on the contrary, are generally regarded as lead-
ing indicators. By leading, the inference is that momentum indicators
are better able to anticipate price than other indicators, such as trend
indicators (i.e., moving averages). Momentum indicators are said to
anticipate prices by letting technicians know when a given market is
overbought or oversold and likely to reverse.
Unfortunately, the traditional use of overbought and oversold conditions
as trading signals is a complicated one. As I will show later in the sections
on stochastics and RSI, the way that most technicians use these indica-
tors actually works against the capacity of the indicators to lead prices. In
other words, it is not so much that momentum indicators do a poor job
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viii | The Three Secrets to Trading Momentum Indicators
as leading indicators. Rather, the problem is that too many technicians
allow the momentum indicator to lead them in the wrong direction!
All of this builds to the most important conclusion of this book: there
is no faster trading signal than price action properly interpreted.
And for the momentum trader who looks to maximize reward versus
risk (to be long on the up days and short or out on the down days), the
sooner the signal is received, then the sooner the high reward/low risk
trade can be made.
This is true whether or not the trader is looking to exploit a surge in
momentum by buying a breakout or selling a breakdown. This is true
whether or not a trader is looking to exploit a temporary drop in mo-
mentum by buying a dip or selling a bounce. This is true whether or not
a trader is looking to exploit the exhaustion of momentum by buying a
bottom or selling a top.
This is why I am making a big deal out of Japanese candlestick chart-
ing. While it is true that there is much more familiarity with Japanese
candlesticks today in 2009 than there was ten years ago, it remains the
case that many technicians use candlesticks sloppily or inaccurately.
It probably would not be too much to say that too many traders have
become as lazy with Japanese candlesticks as they have with their mo-
mentum indicators!
Japanese candlesticks are powerful tools for market technicians—ar-
guably, they represent the “best thing since sliced bread” of technical
analysis. But used incorrectly, Japanese candlesticks can be just as de-
structive to accurate analysis and trading as any other technical tool.
In fact, it might be the case that misusing Japanese candlesticks is more
dangerous because their apparent simplicity can lead technicians to
think they know more than they do about how to use and not use Japa-
nese candlesticks.
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Introduction | ix
I’ve already warned that some of the most popular momentum indicators
are being used in ways that do not maximize their utility as momentum
indicators. The primary problem, to put it bluntly, is a tendency to panic
when momentum indicators reach “extreme” levels of overbought and
oversold. While I will present a completely different way for momentum
traders to think about overbought and oversold market conditions in
the course of this discussion, I also want to point out here that many
of the problems of momentum indicators are solved by working back
toward the way that moving average-based indicators, typically consid-
ered “trending indicators,” inform traders about price.
One example of a very effective moving average-based momentum in-
dicator is the triple-smoothed exponential moving average, or TRIX.
This indicator, developed by trader and founder of Technical Analysis
of Stocks & Commodities magazine, Jack K. Hutson, has both of the key
advantages that a quality momentum indicator must have.
One important condition is that the momentum indicator must alert
traders to momentum opportunities while momentum is still increasing
rather than cresting. The second important condition is that the mo-
mentum indicator must allow the trader to remain in the trade when
there are drops in momentum that are not necessarily reflected in price.
The TRIX indicator (more will be discussed in a later chapter) takes
an exponential moving average (A), then takes an exponential moving
average of that initial moving average (B), and then takes an exponential
moving average of that already twice-averaged moving average (C). The
trader then takes a one-day rate of change measurement of C.
As Hutson wrote of his indicator nearly 30 years ago (1982):
While this oscillator is not the answer to all our trading prayers, it
certainly is an improvement over many. It contains two essential
ingredients required in stock or commodity trading: a filter of ran-
dom market noise, and a positively timed signal.
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